Sustained Growth and R&D: The Pharmaceutical Industry’s Divide

Nearly two years since AstraZeneca shafted Pfizer’s $104-billion courtship offer, Pfizer and Allergan announced on Nov. 23, 2015 that they were going to merge with a $160-billion mega-deal – the largest deal in the pharmaceutical industry’s history. After the deal is finalized in later 2016, the new Pfizer Plc will be the largest drug-maker on the planet, surpassing Swiss multinational Novartis, French pharmaceutical giant Sanofi, and former American rivals Merck & Co. and Johnson & Johnson in projected revenue. The magnitude of this deal has not only raised questions about the synergistic aspects between the two firms, but has also drawn major attention to the motives of the deal.

The synergistic aspects of the merger can only be speculated on in the context of size. Pfizer Plc will receive an enhanced and valuable revenue channel through Allergan’s flagship drugs that treat depression, dry eyes and skin as well as Pfizer’s blockbuster drug Lipitor, used to treat high levels of cholesterol and Viagra, for erectile dysfunction. Aside from revenue, Pfizer Plc’s operating cash flow is estimated to be $25-billion, while the next largest pharmaceutical firm, Novartis, has a $14.66-billion operating cash flow. Pfizer Plc is incomparably large, and given its orientation regarding product diversification, revenue and cash, the size of the firm itself can be major aid in overcoming synergistic hiccups, such as redundant streamline processes, managerial and upside biases, and brand and identity crises, that it will face in its pursuits in a much larger pharmaceutical landscape.

Aside from the synergy speculations, the motives of the merger are quite interesting, especially in the context of the domestic pharmaceutical industry and its future. According to an article on NPR, Pfizer CEO Ian Read says that the merger would “create a leading global pharmaceutical company with the strength to research, discover and deliver more medicines and therapies to more people around the world”. However, the deal itself is structured in a way that allows Allergan to purchase Pfizer, allowing Pfizer to re-establish its headquarters from its original location in New York to Ireland, where Allergan is situated. The reason for this inversion is that it allows Pfizer to enjoy a lower corporate tax rate in Ireland at around 17 percent to 18 percent as opposed to the U.S. effective tax rate at 25 percent. According to an article on The New Yorker, Read offers the justification that the merger would put Pfizer “on a more competitive footing within [their] industry” in reference to the fact that other competitors such as Novartis and Astrazeneca, headquartered in Switzerland and England respectively, enjoy lower tax rates.  But there is generally little evidence to support the idea that Pfizer needs this higher footing. Pfizer, headquartered in the United States, can make use of the technical expertise and abundant capital, as well as receive federal support for research ventures, as shown in its collaboration with the National Institutes of Health. And in fact, Pfizer has generated around $11.4-billion in net income only last year. Thus, the merger seems to be a product of clever financial engineering and the employment of cost cutting decisions suggesting its motive is financial.

In terms of the pharmaceutical industry and its future, there seems to be a clear divide between the firms that focus on the research and development (R&D) required to create blockbuster drugs, and which firms focus on marketing and the sales of these drugs. Historically, most firms competed in the pharmaceutical industry through R&D and attempting to obtain patent approval for their drugs. After a firm created a novel drug and obtained patent approval, the firms would enjoy ample profits due to strong demand for the new drug and the valuable patent protection. Upon patent expiration, the relevant market would be flooded with generics, and prices would be driven down. The same firm would then continue to R&D new drugs, and this cyclic industry behavior would be continued. In the last couple of decades, the discovery and creation of blockbuster drugs has slowed down. Thus, larger firms have focused on cost-cutting measures, leading to the R&D divide of recent. Now, large pharmaceutical firms and small pharmaceutical firms are distinct when R&D as a metric is examined. Smaller pharmaceutical firms are now doing most of the innovation required in developing new blockbuster drugs and larger pharmaceutical firms are coming in at the later stages of the drug production pipeline, perhaps integrating these smaller firms into themselves and using advantage of their distribution channels and abilities in dealing with regulations to generate revenue.

This general trend is evidenced in merger history in the pharmaceutical industry in the last decade. For one, Pfizer and Warner-Lambert merged in 2000, motivated by the ease in which Pfizer could bring Warner-Lambert’s drug Lipitor into markets. In addition, Pfizer and Pharmacia merged in 2003, mainly for control of Pharmacia’s anti-inflammatory drug Celecoxib. While both Warner-Lambert and Pharmacia were relatively large firms, the principle or key reason behind these mergers was for the acquisition of blockbuster drugs by the larger firm from the smaller firm for the purposes of marketing and distribution. In the same vein, the American biotechnology company Gilead paid $11-billion for Pharmasset and its antiviral drugs in 2012, and Merck & Co. purchased Idenix, another biopharmaceutical firm, for its Hepatitis treatments in 2014 for $3.9-billion. Both were smaller purchases than those of Pfizer in the last decade, shedding more light on the big pharma small pharma divide on which firms do the innovation in the industry.

So, what the Pfizer- Allergan merger means for the industry is an extension and magnification of the trend that has been occurring for the past couple of years, bringing it to a larger scale. In fact, the Pfizer and Allergan deal can be viewed in light of this trend in itself, as Pfizer’s purchase of Allergan could be labeled as a purchase of growth. This is given the fact that Pfizer’s revenue decreased by five percent each year for the last five years and Allergan’s increase in revenues by roughly 40 percent year over year. According to an article on the Economist, Nils Behnke, a partner of Bain & Company, states that large pharmaceutical companies got around 70 percent of revenues from drugs that were not developed in-house, showing the extent to which large companies, in a sense, rely on smaller firms to do the innovation for them, a reliance that is so inherent that the merging behavior and motives are not very likely to change.

This stagnation is concerning from the consumer point of view, especially given the fact that there is unflagging demand for drugs of all kinds. Large pharmaceutical firms seem to sustain themselves through acquiring small firms that innovate, rather than sitting down and innovating for themselves, even though they have sufficient financial capital do so. Therefore, the powerhouses of the industry are leaving the job of innovation to the smaller firms, which have much less resources and financial capital to do so, putting into question not only the quality of drugs being produced, but also the starved innovative potential. This concern is only ameliorated within limits by the profit incentive of scientists and smaller firms in creating innovative drugs to solve problems and be bought-out in a lucrative acquisition.

It will be interesting to see how these already large pharmaceutical firms will become, and what it will mean for R&D as this industry trend progresses. The new Pfizer Plc has already announced plans to split itself into two, one company would focus on selling generic drugs, and the other would revolutionize and create, suggesting that perhaps there is a limit to how large a pharmaceutical company can become while properly managing itself. But given the discussed industry trend, the effective, marginal innovative power of a ridiculously large firm versus a large firm’s is not substantial.